Engineering of the Post-Pandemic Bank Capital Relief Securitization

By: Alexander Gold, Chairman of Bankograph Capital Management Pte Limited           May 2020

Why banks need these transactions?

“Almost 60% of banks worldwide could be wiped out in an economic downturn because of their low return on equity as well as technology challenges.” – McKinsey and Co., 2019                          

·       Current structural dislocations underpin unique opportunities for institutional investors to arbitrage on regulatory and economic asset risk weightings

·       Increasing regulation has required banks to improve capital adequacy, forcing banks to share risk with investors even before COVID-19. 

·       The need for fresh capital is becoming ever more evident now and the banks’ positions will get worse in the coming months

·       Both direct asset sales and structured capital relief securitization are viable solutions for banks looking to improve their capital and leverage ratios

Banks need to raise capital

Banks require equity (or equity-like) capital to provision for unexpected losses resulting from banks’ business operations. Expected losses, on the other hand, are covered by provisions or write-downs in the value of the ‘impaired’ assets.

In theory banks would never need equity capital since the income earned on the assets would exceed the income generated by its liabilities and leave a positive ‘net interest margin’ from which banks could pay running costs and have excess left over for profit. That is if loan assets in banks always performed as per their modelled expectations, which as history shows is not always the case.

Regulators have a vested interest in the amount of equity banks hold and therefore the more equity a bank holds, the better- ultimately if things go wrong the regulators, or rather taxpayers will be left to bail out the depositors.

The difference between regulatory and economic capital

When it comes to determining how much capital banks need to hold, there is, however, a difference between what the equity holders may believe constitutes an adequate capital buffer (economic capital) and what the regulators require (regulatory capital). That is because the equity holders expect sufficient ROE for their capital and would not like the bank to hold too much idle capital relative tothe ratios that regulators deem adequate.

The regulators are primarily concerned about financial system’s stability and protecting depositors and the taxpayer from being exposed to any losses generated by a bank in excess of the amount of equity capital a bank has. Since the experience of the Global Financial Crises, in particular, regulators have been forced to think about ways in which to safeguard taxpayers so that they are protected from having to ‘bail-out’ failing banks should governments or central banks be forced to step in again. 

Regulators assign a ‘risk weight’ to every loan asset class. To illustrate,  government bonds may have a risk weight of zero whereas investments deemed particularly risky – such as unlisted equity exposure – may attract a risk weight of 400%, in comparison. The aggregate risk weights are translated into a capital requirement by having the banks hold capital equal to a percentage, for example 10%, of its risk-weighted assets (Capital Adequacy Ratio);

In addition, banks are required to provision capital against other risks, including operational risk, interest rate risk, etc.

The amount of regulatory capital a bank needs to hold is determined by the standardised criteria not by the actual assessment of asset quality and as a result the capital required to be held in the regulator’s eyes is often times much higher than actual risk on the bank’s books. 

On top of this, because the regulatory authorities are prone to further increasing capital requirements, banks are forced to have a buffer over and above the regulatory minimum. Banks are all too aware that falling below this minimum would have negative consequences for the bank’s management as well as its stock price, with banks subject to regulatory stress tests performed by the respective Prudential Regulators.

Asset sales and Securitization transactions are viable solutions for banks

Successful banks always look for structured solutions, alternative to shareholder dilution through capital raising, to be able to continue their provision of credit.

Typically the structured capital management solutions aim to achieve the following outcomes:

·       Dynamically adjusting the size of banks’ balance sheets by selling assets from time to time;

·       Restricting the amount of loans made relative to the amount of loans that are maturing, i.e. shrinking the balance sheet; or

·       Reducing the risk-weighted assets by transferring the risk of first-loss on the assets, in a manner that the regulator considers sufficiently risk bearing to allow the banks to hold less capital as determined by the risk weight measure – but, in the meantime, selling first-loss does not reduce the size of the balance sheet.

Capital Relief Securitization Concept 

There may be an alternative approach of structuring a Hybrid Capital Relief Securitized Instrument. 

This type of securitization model facilitates the 3-pronged, hybrid strategy of economically efficient management of bank’s capital by an integrated structured security, which achieves the following:

1.    Sell high risk weighted asset assets

Banks do not necessarily need to hold on to all the assets they originate. Banks can generate healthy profit margin by moving these assets away from the balance sheet.

From investors’ perspective, owning bank assets (e.g. for example credit card receivables book) that on a loss-adjusted basis have consistently outperformed other low-risk investments e.g. secured corporate bonds - is an attractive proposition.

This is a great situation for banks and non-bank investors alike. Banks can originate these loans to the same exacting standards as the regulators demand and, from time to time, free up some capacity to do more lending by selling some assets to institutional investors.

Importantly, banks can still maintain the customer relationships and service the assets. The benefit of selling assets is that most of the metrics that cause the banks to hold capital in the first place – leverage ratio, risk weight, operational risk, interest rate risk et al – are overcome.

This is the cleanest outcome for a bank from a capital management perspective. For low-risk assets with high risk weighting, such asconsumer finance loans, where the ‘leverage ratio’ measure determines the disproportionate effect on the capital requirement, selling them is the only logical way to reduce their capital position.

The inherent need for these transactions has given rise to securitised finance strategies. One other consideration is what the investors in the assets that can do with them should things go the wrong way. 

Considering these transactions, investors are generally looking at assets that can be serviced by a third party (back-up servicer) and financed cost effectively through long-term financing. Consumer loans, credit cards and mortgages are popular among lenders since they can analyse them statistically (large numbers of small homogenous loans). 

Homogenous assets that allow a greater level of granularity tend to be better suited for asset sales, because investors like to invest inthem and financiers like to finance them. Importantly, selling such assets also helps banks reduce capital adequacy ratios and the bank can make profits on sale, since the economic risk those assets carry is less than regulatory risk weighting, assigned to them.

The downside to selling assets is that the bank also loses the ongoing interest income earned on the assets. This reality inherently imposes a constraint on what types of assets a bank could sell. The types of assets that a bank cannot sell for practical or reputational reasons – unutilized revolvers, for example.

2. Sell first-loss risk on assets

A first-loss protection mechanism refers to an instrument designed to limit the amount of capital which is exposed first should there be a financial loss on a security. Therefore banks can avoid selling assets by selling a “limited insurance” on the unexpected loss. 

However, designing effective first loss protection instruments to unlock finance for bank asset types can be a complex task. The financial engineering of these instruments must not only consider the credit worthiness and the financial profile of the investment, but also look at the cost at which instruments may be structured, the most effective ways to finance and offer them.

These structures can take the form of cash facilities or guarantee mechanisms based largely on global precedents in the securitization space, such as excess spread (the difference between the gross yield on the pool of securitized assets and the vehicle’s cost of financing), cash provisions (unencumbered liquidity pools or contingent credit lines available in case of liquidity needs ) or overcollateralization (which occurs when more collateral than needed is posted to secure financing). However, as in regulatory capital adequacy, underutilization of protection capital generally leads to an increase to cost of capital to the bank.

3.    Raise Equity-like Capital

Inclusion of equity-like (e.g. perpetual bond) capital into the structured products allows bank to offer investors enhanced return on capital and makes risk return ratio attractive for capital markets. It also allows bank to accelerate asset growth as raising capital and selling assets within the same financial instrument solidifies bank’s economic capital and, in the meantime, addresses regulatory concerns.

Utilising proprietary approach and technology, it is possible to engineer bespoke capital relief solutions which enable banks to cost effectively address capital management needs, and in the meantime offers investors above market returns and exposure to high quality and low risk assets.

This Securitization Model does not reduce balance sheet size, and further external management prudential simulation criteria is applied, so there is a better governance, increasing bank soundness and reputation. 

Opportunity for Investors

Investors can acquire exposure to low risk bank assets by investing in bespoke structured securities, and achieve enhanced returns by participating in managed first loss risk component, which forms a synthetic simulation of bank balance sheet. 

Disclaimer: Singapore – Accredited and Institutional Investors

The information is intended for Professional Investors / Accredited & Institutional Investors/Qualified Investors ONLY as defined in your relevant jurisdiction. It should not be construed as a solicitation of an offer to buy or offer, or recommendation, to acquire or dispose of any security, commodity, investment or to engage in any other transaction, nor it should construed as investment advice or as a recommendation or a representation about the suitability or appropriateness of any advisory product or service